It is important to distinguish cash market from futures markets when looking at a particular commodity. Many people do not realize that there is a difference between the two. The futures market is essential to a producerís need to hedge against the actual commodity that they hold in their warehouse. In the paragraphs to come I will discuss the differences between cash markets and futures markets, and their advantages as well as disadvantages.
There are two basic options that exist for producers who want to forward price: forward pricing through cash contracts, and forward pricing directly through the futures market. Producers have commonly used the cash contracts, but did you know that only 5% of all farmers in the US use the futures market directly? Why would this be? Are cash contracts that much better than the futures market? Probably not; the real reason lies in a lack of knowledge.1
Letís take a brief look at the advantages and disadvantages of forward pricing in the futures market vs. forward pricing through the cash market. Perhaps the most important point to keep in mind when discussing cash contracts and the futures market is that each time a contract is offered to a producer, someone is making that contract available by using the futures market. Because of this, cash contracts Ė at any point in time Ė will usually be less in price than a forward price in the futures market. By using a cash contract, we are paying someone else to forward price in the futures market for us.
Another advantage offered by using the futures market as compared to cash contracts results from the added marketing flexibility offered through the futures market. You can usually offset your contract at any time, meaning you do not have to deliver on the futures contract. With cash contracts, however, you are locked into delivering the amount of product at the price specified. This can create problems when crops fail to meet contracted levels or when potentially profitable copper prices must be passed up because of the fear of over-contracting.
Of course, all is not gravy in the futures market. Some of the disadvantages include the need of putting up margin money (good faith money required in order to trade futures contracts), the complexity of the market, and the understanding required to trade contracts. Another disadvantage is the inability to lock in an exact price (the price relationship between futures and cash markets, called basis, will fluctuate within a small range making a precise determination of forward prices offered impossible). Also, many producers desire to price less than the minimum standard contracts called for in futures markets. An example of this problem would be the producer with less than 25,000 pounds of copper (smallest copper futures contact) or 44,000 pounds of aluminum (smallest aluminum futures contract).
Trading in futures and options involves a substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future results.